Trading Basics

Stop Loss Orders

Stop loss orders ("stops") are limits set by traders at
which they will automatically enter or exit trades - an order to buy
or sell is placed in the market if price reaches a specified limit.

The first discipline that any trader should master is to
always limit your losses.

A stop loss order is set to limit a trader's potential loss. The
stop loss is placed below the current price (to protect a long
position) or above the current price (to protect a short position).

Example: If you purchase 1,000 IBM at $90.00
you may decide to place a stop loss as follows:
SELL 1,000 IBM IF
price is less than or equal to $87.00
If price falls to $87.00 your order will be activated.
Your loss is limited to $3.00 per share (plus brokerage).

As a rule: avoid markets with low liquidity where
extreme price fluctuations are possible.

Market Stop Orders
This is a conventional stop loss order - the stop activates a market
order to sell (or buy) at the prevailing market price.

Limit Stop Orders
The limit stop activates an order to sell at the prevailing market
price but not below a specified limit (or buy at the prevailing price
up to a specified limit).

Fixed Price Stop Orders
The stop loss activates an order at a fixed price. Some exchanges refer
to these as limit stop orders so check that you are using the
correct stop loss order.

Limit stop orders are recommended for entering a trade:
they have a greater chance of success than fixed price
orders but are not as open-ended as market orders (where
your order will be executed no matter what the market price is).

Market stop orders should be used to exit trades: to ensure
that the order has the best possible chance of execution. Never
hold on to securities if price falls sharply - in the hope that
they will recover. Edwin Lefevre sums up the predicament in
Reminiscences of a Stock Operator :

It was
the same with all. They would not take a small loss at first but had held
on, in the hope of a recovery that would "let them out even."
And prices had sunk and sunk until the loss was so great it seemed only
proper to hold on, if need be a year, for sooner or later prices must come
back. But the break "shook them out," and prices just went so
much lower because so many people had to sell, whether they would or not.

Stop loss orders do not always work perfectly. If a major
support level is
breached, a large number of stops may be activated at the same
time. Sellers will far exceed buyers, causing price to fall
sharply and leaving sell orders unfilled. In extreme cases there
may be no buyers at all for a security -- not at any price.

Imperfect as they are, stops are still an effective mechanism
for limiting risk and protecting capital.

If stops are not accepted in a market, set your own limits
and place buy or sell orders when the price is reached. Use
SMS alerts if they are available from an online broker.
Self-discipline is required to execute stops without hesitation.